Chinese Surge in Construction Explains Pickup in Base Metals Stocks

Alright then. Now we think we’ve figured out what’s going on. It’s been a bit confusing over the last week. But in today’s Daily Reckoning, we reveal the real plot behind the surge in commodity prices and the flight from Treasuries.

But first, the market action. Crude oil kept on keeping on and closed up 3.4% in New York at $68.58 a barrel. Oil is up 54% this year.

Overall, the Reuters/Jeffries commodities index was up 3.07%. Oil, copper, gold, stocks, the euro-pretty much anything that is NOT the U.S. dollar or U.S. Treasury notes and bonds-is going up. At 81 cents versus the greenback, the Aussie dollar is at an eight-month high.

So it’s happening again. Can’t you see? Everyone is moving out of U.S. Treasuries and into commodities and stocks because the recession is over! Demand for government debt is falling. Demand for risk is rising! Dollar weakness equals economic strength!

Well. Maybe not. But that’s the story that’s being spun today. China’s Purchasing Manager’s Index expanded for the third month in a row. The dragon is breathing fire and building roads. “By the end of April, China had built 20,000 kilometres (12,430 miles) of rural roads, 214,000 low-rent homes, 445 kilometres of highway, and 100,000 square meters (1.08 million square feet) of airport buildings under the stimulus plan,” reported China’s National Development and Reform Commission on May 21.

Talk about shovel ready.

The Chinese surge in building and construction activity goes a long way to explaining the pickup in base metals prices and base metal stocks. But that just makes yesterday’s news even more curious. Matthew Murphy over at the Age reports that the China Iron and Steel Association (CISA) has rejected the benchmark iron ore price negotiated last week between Rio Tinto and Japanese and Korean Steel mills.

That agreement cut the annual contract price for fine ores by 33% and for lump ores by 44%. According to Chamber’s report, the CISA is rejecting the agreement because, “those cuts did not reflect the real supply and demand situation in the international market.” “These prices do not reflect a mutually beneficial, win-win relationship for steel makers and iron ore suppliers,” said a CISA statement. “CISA therefore cannot accept these prices and will not follow them.”

We’ll see about that. Maybe the Chinese are pushing for an even bigger cut. This is the peculiarity of the iron ore pricing system. Prices are negotiated between producers and consumers (Asian steel makers) on an annual basis. Last year, that worked out great for BHP and Rio Tinto. The 2008 contract price average was nearly double the 2007 price.

This year, even with a 45% cut from the 2008 price, the eventual price will still be higher than the 2007 price. That’s not bad at all for Aussie ore producers, considering how awful business has been for everyone everywhere else. It shows a lot more resiliency in pricing-and a lot stronger Chinese demand-than you might expect.

What does it mean for shares? Well, if the price cuts in the contract price are smaller than expected, traders are going to revalue the ore producers at the new contract price. And of course, we’re assuming that Chinese steel production is going to remain stable.

There is always the possibility that there is already way too much capacity in the Chinese steel industry and that ore demand, as resilient as it is, does not reflect a sustainable economic situation. But we’ll just have to see about that won’t we?

Whatever the fate of Chinese steel production, it’s pretty clear China is beginning to swing its economic weight around. U.S. Treasury Secretary Tim Geithner was in Beijing promising that the U.S. would be a good borrower and reduce its deficits and not to worry about them so much and just make nice please and stop worrying and smile for the cameras would you please?

Meanwhile, former Chinese central bank adviser Yu Yongding was more direct. “I wish to tell the U.S. government: ‘Don’t be complacent and think there isn’t any alternative for China to buy your bills and bonds’,” Yu said in an interview yesterday. “The euro is an alternative. And there are lots of raw materials we can still buy.”

Yes, there are. And by the way, why not a gold exploration boom? Gold mining requires lower capital overheads than bulk materials extraction. And with a rising gold price, it’s worth a punt. If the gold mania really takes off (it’s starting), look for a boom in the junior explorers.

But back to Yu. Yu has encouraged the U.S. to think about China’s interests, “So that your own interest can be protected…You should not try to inflate away your debt burden.” He hinted that if the U.S. does that, China has options like the euro. “Yes, some people say the euro is very weak…Okay, weak is good, we’ll buy very cheap.”

The man is both a psychic and a good trader. He is also a moralist with an old fashioned sense of fiscal responsibility. “The borrower should keep their promises…The U.S. should be a responsible country.”

Note to Yu. U.S. central bankers and government policy makers gave up being responsible a long time ago. 1913, 1971, 1980…take your pick. The policy of perpetual debt and gradual inflation has been around for nearly a century now. The only trouble is that the liability side of the Federal balance sheet has exploded. Hence the need for greater inflation via quantitative easing…and the situation we all find ourselves in today.

It’s just the sort of thing that could trigger another dollar crisis. And THAT is what’s really behind the market moves, we think. It’s not a cyclical rotation out of bonds into higher risk assets because everything’s peachy. It’s a stealth retreat from U.S. bonds under the covering story of economic recovery.

But what’s really going on is that investors are heading for the door on U.S. debt. Ten-year yields spiked again today and bond prices fell. Goldman Sachs reckons the U.S. will have to borrow over $3 trillion this year to finance new deficits and roll over old ones. And if it can’t borrow it, the Fed will have to buy it.

For some reason, the Fed is confused about why bond yields are rising. A Reuters headline reads, “Federal Reserve puzzled by yield curve steepening.” Are investors ditching the dollar and U.S. bonds because the U.S. credit rating is in jeopardy? Is the huge new supply of debt causing the Bond Vigilantes to protest inflation and punish President Obama buy selling bonds? Or are investors just so confident in the economy now that they feel no need to hide out in the government bond market until they get the all clear signal?

Hmm. What’s so confusing again?

A few years ago, we called it “The Money Migration.” That still seems like the right description today. You’ve got a debtor nation whose largest corporate institutions are failing (perhaps a preview of State failure). It’s shipped its industrial infrastructure off-shore and replaced it with a financial industry that thrived on credit and derivatives. And now you wonder why investors are pushing interest rates on your debt up?

It’s not hard to see who’s in the global driver’s seat now. It’s creditors and producers. And for Australia’s sake, that’s good news. Because the world’s largest creditor and producer is keenly interested in Australian assets, both as a hedge against the fading greenback and as a key input to its long-term expansion, which seems to be coming along just fine for now.

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

Yes sometimes things are exactly what they seem. There is no conspiracy, the Chinese are simply building a lot of stuff as they said they were going to do last year. I also do not see why anyone should be surprised that the Chinese are trying to pay less for commodities…it is called price negotiation, happens all over the world every day between buyers and sellers. It is also time for “payback” after BHP, RIO etc. hit them with over the top prices (and shipping charges) during the boom.

Australia is in the best position to cash in on the crises. However, Australia must be realistic. High commodity prices will not be sustainable in the long run. The 2008 melt down was cause partly by high resourse prices. Good business must be on going and good relationship with customers are good for business. A very sucessful and wise uncle gave me the following advice: If you go into business to make money, the chances are you will go broke, no one want to give you his money. If you go into business to provide quality products at reasonable prices,… Read more »

I feel well short of a grasp the story when it comes to forecasting Chinese resource consumption. I remember Gotliebson signing on with those forecasting exponential increases in iron & copper based on projections for new electricity generating capacity but they were looking backwards and forgot that the substantial part of the grid infrastructure was built in earlier periods to accomodate exponential growth. We know the Chinese were stockpiling and that the rise in the Baltic began before the Chinese stimulus but I haven’t ever seen any decent stockpile reports and I am sure the Chinese are in no hurry… Read more »

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